Manecon Chapter 6

PRESENTATION
CHAPTER 6
COST
ANALYSIS
Prepared by
Group 2
COST ANALYSIS IS
FUNDAMENTAL FOR:
Managerial decision-making
Influencing profitabilty
assessments
Production changes
Strategic decisions related to
output and costs
CHAPTER PROBLEM
The sporting goods frim is facing a profitability challenge with its new line
of boys’ cross-training shoes. Despite being easy and inexpensive to produce,
the current price of $36 per pair does not cover he total costs, including direct
costs and allocated overhead. To address the issue, management is
considering options such as raising the price to $40 per pair, but this may
impact sales, or optimizing production volume to minimize direct costs per
unit.
What type of cost analysis could guide the firm in determining its profit-
maximizing course of action.
Flow of Discussion
Relevant Costs
Cost of Production
Returns to Scale and

Scope
Cost Analysis and

Optimal Decisions
Relevant Costs 01
These are factors that help
managers decide between
different options. These costs
are the key differences in
income and expenses among
alternatives being considered.
Decision-making Principle
“In deciding among different courses of action, the

manager need only consider the differential
revenues and costs of the alternatives.”
Relevant Costs
Opportunity Costs and
Economic Profits
Fixed and Sunk Costs
Profit Maximization with
Limited Capacity
Opportunity Costs & Economic Profits
Opportunity Cost The measure of benefits foregone in the next-best
alternative when making a decision. It involves
comparing the potential gains or values sacrficed in
choosing one option over another.
Economic Profits The difference between revenues and all economic

costs, including both explicit and implicit costs such
as opportunity costs. It is a more comprehensive
measure of profitability than accounting profit, which
only accounts for explicit expenses.
Illustration:
A money manager decides to start her own investment management
service. She has developed the following estimates annual revenues and
costs (on average) over the first three years of business:
Management fees 140,000 Working capital 80,000

Miscellaneous revenues 12,000 Manager’s compensation 56,000
Office rent (36,000)
Other office expenses (18,000)
Staff wages (24,000)
FIXED COST AND SUNK
COST
Fixed Cost
Cost that remains constant
regardless of the changes in the
activity level.
Sunk Cost
money that has already been
spent and cannot be recovered.
those which have already been

incurred and which are
unrecoverable.
A company spends $5 million on building an airplane. Prior to
completion, the managers realize that there is no demand for the
airplane. The aviation industry has evolved and airlines demand a
different type of plane. The company has a choice: finish the
plane for another $1 million or build the new in-demand airplane
for $4 million. In this scenario, the $5 million already spent on the
old plane is a sunk cost. It should not affect the decision and the
only relevant cost is the $4 million.
Sunk Cost Fallacy
Profit Maximization with
Limited Capacity
The notion of opportunity cost is essential
for optimal decisions when a firm’s
multiple activities compete for its limited
capacity.
Illustration:
Consider the manager of a bookstore who must decide

how many copies of a new best seller to order. Based on
past experience, the manager believes she can accurately
predict potential sales. Suppose the best seller’s
estimated price equation is P = 24 - Q, where P is the price
in dollars and Q is quantity in hundreds of copies sold per
month. The bookstore buys directly from the publisher,
which charges $12 per copy.
COST OF PRODUCTION
NICK GA
C = C(Q)
Short-Run Costs
Total Cost
Fixed Cost
=FC + VC
Variable Cost
Average Total Cost Total Cost
or
Total Cost =AFC + AVC Total Output
Average Variable Cost

Average Fixed Cost Average Variable Cost
Average Fixed Cost = Fixed Cost = Variable Cost
Total Output Total Output
Average Total Cost
Short-Run Costs
Marginal Cost
with labor the only variable input:
where:
PL= price of hiring additional labor
MPL= marginal product of labor
*MC will increase if there is an increase in the price of labor or a

decrease in labor's marginal product.
*Law of diminishing returns applies, labor's marginal product declines,
and SMC rises.
Short-Run Costs
SMC > SAC, overall

average cost
increases
SMC < SAC,

reduces overall
average cost
Short-Run Costs
In Equation Form:
Cost Function:
Short-run Average Cost:
Short-run Marginal Cost:

Long-Run Cost
the firm can freely vary all of the of its inputs
no fixed inputs and fixed costs
all cost are variable
ability to vary all inputs allows the firm to produce at lower cost in long run
shape of the long-run cost curve depends on return of scale

Return to Scale
INCREASING RETURN TO SCALE
% △ in Output > % △ in Input LAC is falling

CONSTANT RETURN TO SCALE
% △ in Output = % △ in Input LAC is Constant

DECREASING RETURN TO SCALE
% △ in Output < % △ in Input LAC is rising

% △ in % △ in Return
Capital Labor Output Input Output to Scale
20 150 3,000 - -
40 300 7,500 100 160
60 450 12,000 50 50
80 600 16,000 33.33 33.33
100 750 18,000 25 12.5
Return to Scale 05
Returns to scale is a term that refers to the
proportionality of changes in output after the
amounts of all inputs in production have been
changed by the same factor.
www.reallygreatsite.com
05
Factors
Influencing
Return to Scale
05
Constant
Average Cost
05
Declining
Average Cost
05
Increasing
Average Cost
MINIMUM EFFICIENT SCALE (MES)
is the lowest output at which minimum average cost
can be achieved.
important in determining how many firms a particular

market can support.
ILLUSTRATION
In a market with a demand for 10 million units per year and a

minimum efficient scale of 100,000 units per year for each
firm. How many firms can the market support or operate at
the minimum efficient scale?
SOLUTION:
CONCLUSION:
High (MES) = concentrated market
Low (MES) = more competitive market

Economies of Scope 07
Economies of scope occur when the cost
of producing multiple goods together is
less than the aggregate cost of producing
each item separately.
It is measured by the formula SC = (C(Q1) +

C(Q2) - C(Q1, Q2)) / (C(Q1) + C(Q2)), where
C(Q1, Q2) is the cost of jointly producing
both goods, and C(Q1) and C(Q2) are the
costs of producing each good separately.
Sources of
Economies of Scope 08
Versatile production processes
Utilizing by-products creatively
Efficient input utilization
Knowledge transfer advantages
Meeting consumer demands
Examples of 09
Economies of Scope
Adaptable Auto Production
Tailored Consumer Offerings
Distinctive Capability Leverage
Flexibility and Innovation 10
The ability to Behavioral factors
produce different and diseconomies of
models under the scale and scope may
same factory roof Large multiproduct impede innovation in Smaller, focused
illustrates flexibility firms may be large firms. research units may
and innovation. reluctant to risk enhance innovation
cannibalizing existing in certain industries.
products, hindering
disruptive innovation.
COST OPTIMAL
AND
ANALYSIS DECISIONS
A Single Product
Two fallacies: 07
“The firm always can increase its
profit by exploiting economies of
scale.”
“If the current output and price are

unsatisfactory, the firm should raise
its price to increase profit.”
THE SHUTDOWN RULE
In the short run,
the firm should continue to produce at Q*
(even if it is suffering a loss) so long as
price exceeds average variable cost
In the long run,

the firm should shut down if price falls
short of average cost
In sum, the firm should continue

production because the product
generates a positive contribution,
thereby minimizing the firm’s loss. The
firm suffers an economic loss in the
short run; nevertheless, this is better
than shutting down
INVERTED TRAFFIC LIGHT
Multiple Products
Fixed cost doesn't
11
matter.
The firm can
The correct strategy
produce multiple
is to maximize the
products at a total
product's
cost that is lower
contribution.
than the sum of the
items' costs if they
were produced
separately.
12
13
PRESENTATION
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PRESENTATION

Returns to Scale and

Cost Analysis and

“In deciding among different courses of action, the

Economic Profits The difference between revenues and all economic

Management fees 140,000 Working capital 80,000

those which have already been

Consider the manager of a bookstore who must decide

Average Variable Cost

*MC will increase if there is an increase in the price of labor or a

SMC > SAC, overall

SMC < SAC,

Short-run Average Cost:

Short-run Marginal Cost:

no fixed inputs and fixed costs

all cost are variable

shape of the long-run cost curve depends on return of scale

% △ in Output > % △ in Input LAC is falling

% △ in Output = % △ in Input LAC is Constant

% △ in Output < % △ in Input LAC is rising

important in determining how many firms a particular

In a market with a demand for 10 million units per year and a

High (MES) = concentrated market

Low (MES) = more competitive market

It is measured by the formula SC = (C(Q1) +

Utilizing by-products creatively

Efficient input utilization

Knowledge transfer advantages

Meeting consumer demands

Tailored Consumer Offerings

Distinctive Capability Leverage

“If the current output and price are

In the long run,

In sum, the firm should continue

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